BEIJING—China’s imports of copper and iron ore may drop due to an alleged financing scandal, as banks withhold credit and customs officials tighten checks on incoming shipments, metals traders say.

Western banks are looking into allegations that a Chinese trading company illegally pledged metals as collateral to more than one lender. The operator of Qingdao Port, the eastern Chinese port where the metals are stored, has confirmed that Chinese authorities are investigating allegations of fraud relating to stockpiles of metals.

China’s government hasn’t commented publicly.

Traders have used metals as collateral to bring some $110 billion into China since 2010, Goldman SachsGS -0.08% Group Inc. estimates. Traders who import the metal use the commodity to secure loans from abroad.

That trade, which allows people to take advantage of the fact that interest rates in China are higher than on the offshore loans, is a legal way to circumvent China’s capital controls. It has helped keep metal import volumes high even as China’s economic growth has slowed.

Now, traders say, there are a number of disruptions to this trade related to the ongoing probe and China’s efforts to tamp down big capital inflows that have fueled rapid credit growth.

Customs officials are taking longer to clear metal imports since the allegations of fraud emerged, traders say. “Customs are taking anywhere from 15 to 20 days to up to a month to clear shipments of copper cathodes. Earlier, it used to take seven to 10 days,” said a Qingdao-based metals trader.

Customs officials weren’t immediately available to comment.

Authorities were worried about the pace of growth of metals-backed financing even before the current allegations. In April, regulators raised concerns with local governments about the practice. That sent shivers through the market, traders said. In May, iron-ore imports fell 7% from the previous month, while copper imports tumbled 16%.

Imports in the months ahead could be even weaker, traders say. Many banks are starting to withhold letters of credit that are used in commodities financing, they add.

“Things are getting worse and worse. Imports have shrunk in May. It could fall even further in June and July,” said an executive with a Hong Kong-based commodities trading company. “Already, people are finding it very difficult to open letters of credit for import of copper and other metals in banks in China.”

An estimated one-third or more of Chinese metal imports are believed to be used as collateral for loans from China’s “shadow banks,” a vast network of loosely regulated lenders. Rather than being used to meet actual demand, these stocks are imported into so-called bonded zones, areas where import taxes don’t apply, and re-exported when they are no longer needed as collateral.

China is the world’s largest importer of many commodities. Its imports represent one of the most closely watched indicators of economic activity in the world’s second-largest economy.

Copper stocks in bonded zones nationwide stand at around 800,000 metric tons, said Li Chunlan, a Beijing-based analyst with the metals consultancy CRU Group. At current prices, that is worth about $5.4 billion.

The premium over spot copper prices buyers must pay to get metal for immediate delivery from Shanghai warehouses has shrunk to $70 a ton, down by more than half from around $185 in December, a signal that more people want to sell rather than hold the stocks, said the Hong Kong-based executive.

Three-month copper prices on the London Metals Exchange are down nearly 10% since the start of 2014. After news of the probe emerged two weeks ago, prices fell sharply but have remained mostly flat in recent days.

Some traders say imports could fall more sharply beginning in August. That is because purchases are made in advance: Problems with financing now would take a couple of months to show up in lower shipments.

Helen Lau, senior analyst with UOB Kay Hian, a Singapore investment and securities-trading company, said prices could fall further if traders are forced to sell collateral to repay loans, dumping metals onto the market.

“The market concern about copper prices is real. I am not saying copper prices will keep falling, but there is a downside risk. Prices will fluctuate. There will be no upside in copper prices in the near term,” she said.

Others say real demand for metals like copper and iron ore for industrial purposes will limit further declines in imports.

The official probe so far appears confined to Qingdao and another nearby port, neither of which is a major player in commodities financing, compared with larger hubs, such as Shanghai. The investigation is unlikely to discourage many traders who still want to import metal for use as collateral in legitimate financing plans, CRU Group’s Ms. Li said.

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About bambooinnovatorKB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund.
Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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